A decomposition method for optimal portfolios with regime-switching and risk constraint

Jingzhen Liu, Ka Fai Cedric Yiu*, Tak Kuen Siu

*Corresponding author for this work

Research output: Contribution to journalArticle

Abstract

We study an optimal investment problem for an investor who faces a dynamic risk constraint in a Markovian regime-switching environment. The goal of the investor is to maximize the expected utility of terminal wealth subject to the dynamic risk constraint specified by a proportional Value at Risk (VaR). By transforming the stochastic optimal control problem associated with the optimal investment problem into a deterministic control problem, we obtain a closed-form solution to the optimal investment problem for the case of a power utility. To evaluate the value function, we employ a numerical approximation method based on a piecewise constant approximation to the modulating Markov chain. A numerical example is given to illustrate the impact of the dynamic risk constraint on the optimal investment strategy.

Original languageEnglish
Pages (from-to)269-276
Number of pages8
JournalRisk and Decision Analysis
Volume3
Issue number4
DOIs
Publication statusPublished - 2012

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